hand grabbing money bag

Incorporated professionals in Ontario and New Brunswick will benefit from their provincial governments choosing not to adopt federal measures that will result in either a complete loss or a reduction of the small-business deduction (SBD) for Canadian-controlled private corporations (CCPCs) that hold more than $50,000 in passive investment income.

CCPCs in the two provinces will continue to benefit from the $500,000 SBD at the provincial level. According to Ontario’s 2018 fall economic update, some 7,900 CCPCs in the province will benefit from a tax savings of up to $40,000 per year. In New Brunswick, CCPCs will benefit from tax savings of up to $57,500 per year, according to a KPMG LLP March 2019 TaxNewsFlash.

Peter Merrick, income- and capital- enhancement consultant at theIceSolution.com in Toronto, attributes Ontario’s stance to the “pro-business” nature of its government, a comment that can also be applied to New Brunswick’s government.

Nonetheless, CCPCs in the two provinces that have active business income above the $50,000 threshold still must pay the higher federal tax rate, but will have access to the provincial small- business rate regardless of how much passive investment income they earn.

CCPCs not incorporated in Ontario or New Brunswick still are subject to the new small-business tax rules on both their federal and provincial tax bills.

Financial advisors will therefore have to ensure that their CCPC clients put appropriate mechanisms in place to minimize the impact of the tax changes. “The changes will force businesses that were willing to write a cheque to pay their taxes to look at alternative planning methods,” Merrick says.

CCPCs derive passive investment income from their investments in stocks and bonds, rents, royalties, non-exempt life insurance policies and dividends – sources that are not directly related to the CCPCs’ business activities.

There are reasons for CCPCs to keep business income in their corporations beyond the fact that the income is taxed at a lower rate than if withdrawn by owners personally. Those reasons include providing access to money for working capital, business- development initiatives, protection against an economic downturn, funds for retirement and to cover the cost of sick and parental leave.

However, recognizing that businesses previously enjoyed a tax-deferral advantage by investing active business income through their corporations rather than personally, the federal government decided to dampen that advantage.

Merrick says the changes are “very punitive” for business owners whose savings held in their corporations can be seen as a “credible reward system” for working for themselves. Doctors, for example, fought hard to set up professional corporations, but now are punished by the tax change, he says.

The $50,000 threshold for investment income is based on the federal government’s estimate that this level of income represents approximately $1 million in invested assets, assuming a 5% return. Only a small percentage of businesses typically have $1 million to invest, Merrick says.

Jim Witty, vice president of tax, retirement and estate planning at CI Investments Inc. in Toronto, says larger CCPCs are restricted already from accessing the SBD because it is phased out for CCPCs with more than $10 million of aggregate taxable capital employed in Canada, and is eliminated when aggregate taxable capital reaches $15 million. Therefore, the tax change will affect only CCPCs with taxable investment income between $50,000 and $150,000, at which point the SBD will be eliminated.

To deal with the potential tax implications of the new CCPC tax regime, Witty says, advisors should remember that “every small business is different.” He recommends that business owners work with their advisors to determine the most appropriate solution.

The federal change can work in favour of business owners who have income above the $50,000 threshold if they intend to take money out of the corporation as dividends, which benefit from a favourable tax rate.

Merrick says a variety of structures can be used to reduce investment income and preserve the SBD. While some structures are sophisticated, others are more common. Business owners can choose to invest income in a corporate-owned life insurance policy, through which the death benefit may be paid as a tax-free dividend, or fund an individual pension plan that is not owned by the corporation.

Business owners also can consider paying themselves a sufficient salary to maximize their RRSP or TFSA contributions – in which case employment and income taxes must be paid when any of the funds are withdrawn.

Merrick also suggests using passive income to invest in growth assets, such as real estate, that realize less taxable annual income.

Passive income rules

Until 2018, the first $500,000 of active business income earned by Canadian-controlled private corporations (CCPCs) was eligible for the small-business deduction (SBD) and a lower federal tax rate of 10%, which was reduced to 9% for the 2019 taxation year. Under new measures that came into effect beginning in the 2019 taxation year, the SBD is reduced by $5 for every $1 of investment income above the $50,000 threshold. Using this formula, the SBD will be eliminated when investment income reaches $150,000 in a given taxation year.

Only passive income matters. For example, if a CCPC business has $150,000 of active business income and less than $50,000 in investment income, the business still will be eligible for the full $500,000 SBD.