What to do now there is some certainty.
Last July, the federal government introduced proposals to end the tax deferral advantage that exists when corporate profits are retained in the corporation and invested, as opposed to flowed out to individuals and taxed in their hands. The government suggested eliminating the refundable tax, which would have resulted in a combined effective tax rate as high as 72 per cent on investment income flowed out to individuals.
Fortunately, the government listened to the negative public reaction, and the 2018 Federal Budget suggested a simpler and more targeted approach. This was a huge relief.
What are the new proposals?
In short, the taxation of passive investment income isn’t changing and the current rules will still apply.1 However, passive investment income will now affect the ability to benefit from the small business tax rate on active business income. The current small business limit (SBL) allows for up to $500,000 of active business income to be taxed at the small business tax rate (currently proposed to decline from 10.5% for 2017 to 10% for 2018 and 9% for 2019), as opposed to the general business tax rate which is currently 15% federally. The SBL will be reduced by $5 for every $1 of passive investment income above $50,000, so that the SBL will be reduced to zero at $150,000 of passive investment income. For more information on these proposals, please see our 2018 Federal Budget summary on Repsource.ca.
What does this mean for private corporation investments?
Since the taxation of passive investment income hasn’t changed, the same rules of thumb continue to apply: tax efficiency and tax deferral should still be top of mind. Corporations or associated corporations that don’t earn active income (e.g., investment holding companies) will not be impacted by these proposals. Current planning principles and strategies remain applicable.
However, corporations with active business income that will be negatively impacted by a reduction in the SBL will have additional incentive to reduce the amount of passive investment income they report each year. Below are a few potential planning opportunities for consideration.
Maximize RRSP and TFSA contributions
Pay sufficient funds out of the corporation to ensure individuals can maximize their Registered Retirement Savings Plan and Tax-Free Savings Account contributions. Remember that salary will have to be paid to generate RRSP contribution room, and that you can give your spouse or common-law partner money to contribute to his or her TFSA.
Corporate class mutual funds
For corporate funds, consider tax-efficient investments and employ a buy and hold strategy, where it makes sense, to defer capital gains. Along those lines, corporate class mutual funds can be attractive because they don’t distribute interest and foreign income (the least tax-efficient types of income) and distribute only ordinary Canadian dividends or capital gains, which are more tax efficient and only included at 50 per cent. Furthermore, because mutual fund corporations can pool expenses and losses, funds within them have the potential to reduce taxable distributions and minimize the investment income reported.2
Exempt life insurance does not produce investment income unless there is a disposition of the policy, so it will not impair a corporation’s ability to have active business income taxed at the small business rate. And the rest hasn’t changed – life insurance allows for tax-exempt growth and death benefit proceeds generally received tax-free on death, with the ability to distribute from the capital dividend account.
Individual pension plans (IPPs)
An IPP is a defined benefit pension plan typically established for an individual business owner that offers the potential for greater contributions than RRSPs and protection from creditors under pension legislation. IPP contributions and expenses are deductible to the corporation. The income earned within the plan does not belong to the corporation but rather is tax deferred until paid out to the beneficiary and taxed in his or her hands. This can be an effective way to reduce a corporation’s passive investment income.
However, an IPP also has disadvantages. Professional services are required, and there are setup and ongoing administrative costs. As well, the funds are locked in and not as flexible as funds in RRSPs. Not everyone is a good candidate. Ideally, the individual would be older (at least over 40) and have sufficient T4 employment income. The corporation must also have sufficiently stable cash flow to make the required contributions to the IPP. While IPPs offer many advantages and can be a very effective planning tool, they are not for everyone. They should be considered as part of an overall financial plan and reviewed with a tax professional.
Series T mutual funds
If the corporation is looking to generate cash flow for its investments, for example to pay for a recurring corporate expense such as life insurance premiums, then Series T (or T-Class) mutual funds may be of interest. A Series T mutual fund can provide a regular stream of tax-efficient cash flow from monthly distributions.* All or a significant portion of the distribution received is likely to be considered a tax-free return of capital (ROC). This defers the triggering of capital gains from monthly withdrawals. However, there may still be taxable distributions, as from a regular mutual fund.
Each distribution of ROC is not taxable and reduces the adjusted cost base (ACB) of the investment. When the ACB reaches zero, all further ROC distributions are taxable as capital gains, which is still tax efficient since only 50 per cent of capital gains are taxable.
The release of these new passive investment income rules allows us to plan appropriately for them. Hopefully, the ideas above help.