By Stephen A. Miazga
The perceived unfairness in how shareholders of private corporations were able to build significant investment portfolios inside of those corporations’ small-business-rate after-tax dollars has been on the radar of the Department of Finance for some time. When Finance released its White Paper on July 18, 2017, this topic was explicitly identified as something Finance intended to address through legislation. The conceptual solutions that Finance proposed were criticized by both the business and tax communities as being overly complex and difficult to comply with.
Unlike the vague framework outlined in July 2017, the draft legislation addressing investment income earned by private corporations that was released with the February 27, 2018, Federal Budget was fully formed. Most significantly, a corporation that earns more than $50,000 of investment income will suffer a reduction in its small business deduction limit (the “Grind”) for taxation years beginning after 2018. The draft legislation also contained minor amendments to other provisions relating to the taxation of passive income. What follows is some background on the nature of the proposed measures and practical insights on how they may affect your business.
How the Grind works
The primary implementation mechanism for Finance’s policy objectives is the Grind. In effect, the Grind will reduce the small business limit of a corporation by $5 for every $1 of “adjusted aggregate investment income” (essentially, any investment income not attributable to a disposition of business assets) earned by a private corporation in excess of $50,000 in a taxation year. In Saskatchewan, the Grind will reduce the provincial small business limit by $6 for each $1 of aggregate investment income because of the higher ($600,000) provincial limit.
Because of the significant gap between the general corporate income tax rate in Saskatchewan (27%) and the small business rate (12%), investment portfolios generating income in excess of $50,000 could have a significant impact on the overall corporate tax burden for small businesses. ” To illustrate this point, consider a corporation that earns $51,000 of investment income in a taxation year.
The $1,000 in excess of the $50,000 threshold will result in a $5,000 reduction in the available small business limit for the corporation – resulting in $750 of additional corporate income tax. A corporation that earns $150,000 of investment income will have its small business deduction completely eliminated, at a cost of $85,000 in additional tax payable.
Beyond the loss of the small business rate, the Budget 2018 proposals also restrict the ability of private corporations to recover refundable taxes through the payment of favourably taxed eligible dividends. The specifics of this rule change are outside the scope of this article, but may compound the tax cost of the proposed measures for corporations that earn significant investment income and significant business income.
Who will not be affected?
Finance’s conceptual proposals from July 2017 would have affected almost all private corporations in some way. Fortunately, the Budget 2018 proposals will not have an impact on a large subset of private corporations, including the following:
• Larger private corporations that do not have access to the small business deduction because of the amount of capital invested in the corporation’s business;
• Corporations that no longer operate active businesses and thus no longer earn any income that could be taxed at the small business rate;
• Professional corporations that are members of large partnerships that lost access to small business rates as a result of restrictions enacted in 2016; and
• Private corporations controlled by one or more non-resident persons, which could not claim the small business deduction in any event.
The legislative proposals do contain antiavoidance rules that expand their scope. If any corporation in a larger corporate group is claiming the small business deduction, it is possible that these anti-avoidance rules will apply even if the corporation earning investment income is not earning business income.
Who will be affected?
The short answer to this question is that any corporation owning passive investments generating more than $50,000 of investment income will be affected if the corporation is also earning income that may be taxed at small business rates.
The conceptual solutions that Finance proposed were criticized by both the business and tax communities as being overly complex and difficult to comply with.
There are three distinct groups of taxpayers who are most likely to feel the impact of the proposed passive investment regime:
1) Professionals who practice on their own and who retain the cash they do not spend in a professional corporation that owns an investment portfolio;
2) Mature small businesses that have earned cumulative profits in excess of business reinvestment needs and have invested their retained earnings in passive investments; and
3) New business ventures, which may not have the same opportunity to accumulate significant investment portfolios as businesses that matured well before the new rules come into force.
Potential planning options
Anti-avoidance rules. Finance has proposed broad anti-avoidance rules that operate alongside the proposed passive investment rules. These anti-avoidance rules will
• Aggregate all investment income earned by private corporations within the same corporate group; and
• Cause corporations to be treated as part of the same corporate group if they transferred property between them to avoid the Grind.
As a result of these anti-avoidance rules, it will likely prove more difficult than expected to preserve the ability of any one corporation to benefit from the small business rate if that corporation and other non-arm’s length corporations own significant investment assets.
2018 planning opportunities. For taxation years beginning after 2018, private corporations will no longer be able to recover most refundable tax balances through the payment of eligible dividends. Shareholders of a private corporation that earns investment income should consider whether there is a limited-time opportunity to recover refundable taxes at a favourable tax rate before 2019.
Extracting passive assets from a private corporation using eligible dividends may be an attractive option to avoid the loss of small business rates going forward and may
allow for the recovery of refundable taxes incurred on extraction at a reduced personal income tax rate.
Post-2018 planning. The proposed passive investment rules layer on top of other private corporation tax reform initiatives from Finance (namely, the expanded split income rules announced in the summer of 2017), so tax planning for private corporations has become very complex. If there were ever any one-size-fits-all tax planning solutions for private corporations before 2019, these will no longer exist. Thought and caution must be exercised in implementing any post-2019 strategy to avoid the passive investment regime or any of the other new tax rules.
First published in the June 2018 edition of The Business Advisor.