The Ontario provincial government’s recent announcement that it will not match the federal government’s changes to the taxation of private corporations that limit access to the small business deduction (SBD) tax rate may result in significant tax relief for small businesses and entrepreneurs in the province.
“[The decision is] a huge win,” says Jamie Golombek, managing director, tax and estate planning, with Canadian Imperial Bank of Commerce’s financial planning and advice department, who suggests the Progressive Conservative government’s announcement made in the autumn economic statement in November came as a “total surprise.”
“Accumulating retained earnings within a corporation generates more income, so there is a win there,” adds Aurèle Courcelles, assistant vice president, tax and estate planning, at Investors Group Inc. in Winnipeg.
Although private corporations throughout Canada still will be subject to the new federal rules in terms of the corporate taxes at the federal level, those in Ontario will not be subject to the new rules when it comes to corporate taxes at the provincial level. No other province or territory has announced that it’s opting out of the feds’ new rules.
Some of the biggest beneficiaries of Ontario’s decision not to align with the federal changes, Golombek suggests, will be professional corporations, such as those established by doctors, lawyers and accountants, “who have been accumulating lots of retained earnings in their companies and who now don’t have to worry about [the effect of the feds’ new rules] as much.”
In the 2018 federal budget, the Liberal government outlined new rules, which kick in for the 2019 taxation year, governing access to the SBD rate and passive investment income. When a private corporation earns more than $50,000 of passive investment income in a year, the amount of active business income (ABI) that’s eligible for the SBD rate in the following year is ground down gradually. Access to the SBD rate is eliminated entirely at the $150,000 threshold of passive income and above.
Accumulating retained earnings within a private corporation can allow for a tax-deferral advantage. That’s because when the corporation initially earns ABI, it’s taxed at a lower rate than at the rate the proprietor would pay if he or she earns the income as an individual. If corporate income is taxed at the lower SBD rate, which applies to the first $500,000 earned within a private corporation rather than at the higher, general corporate tax rate, the deferral advantage is greater.
When the income eventually is withdrawn from the corporation as a dividend, it’s taxed in the shareholders’ hands; however, until then, that income can be invested within the corporation on a pre-personal tax basis, creating an opportunity for tax deferral and greater growth.
According to Ontario government’s autumn economic statement documents, the decision not to align the province’s tax rules with the federal government’s represents a tax savings of “up to $40,000 a year for about 7,900 of Ontario’s small businesses.”
However, as income earned in a corporation eventually is paid out in the form of dividends and then taxed in shareholders’ hands, “the $40,000 savings is a deferral that I can invest, but ultimately not an amount that’s [permanently] in my pocket,” Courcelles says.
The federal government’s passive investment income changes were meant to address what the Liberals argued was an unfair tax-deferral advantage that is created when private corporations accumulate large amounts of retained earnings in a corporation. In addition, the feds have estimated that the new rules would affect only about 3% of small businesses — those that earn more than $50,000 of passive investment income in a year.
Ontario businesses that had been considering taking certain tax planning steps — such as creating an individual pension plans or purchasing corporately owned insurance — to deal with the new passive investment income rules may now decide not to go ahead with those measures depending on their individual circumstances, Golombek says: “Some of the more sophisticated strategies may not be as necessary.”
However, other tax planning strategies continue to make sense in most cases. One example is when a business owner takes money out of the corporation in the form of a salary to create RRSP contribution room, and then makes RRSP contributions and maximizes TFSA contributions. Money taken out of a private corporation will reduce the amount of passive investments in the business, and, likely, the amount of passive investment income created.