By Miles Clyne
The Liberal Government is finally giving more clarity on the tax changes they are making to the taxation of passive income in private Canadian corporations. And a pleasant surprise is that they appear to have made intelligent decisions that are not complicated to administer.
Here are a few of the highlights.
1. Budget 2018 relieves small businesses of the complex accounting requirements that the original proposal would have imposed.
2. The new rules would kick in for tax years starting after 2018.
3. In the new proposal, the amount of business income that qualifies for the small business tax rate would be reduced depending on how much annual passive income is declared above $50,000 — and eliminated completely once passive income rises above $150,000.
4. Capital gains realized from the sale of active investments would not be counted under the threshold.
5. Assuming a five percent return, $50,000 in passive income would require $1 million in investment assets. The $150,000 upper threshold would require $3 million in assets.
6. The new rules mean that once a private corporation builds up a multi-million-dollar pool of passive investment assets, its business income will no longer qualify for the federal small business tax rate (which is being lowered to 10 percent in 2018 and to 9 percent in 2019), and instead be taxed at the regular corporate tax rate of 15 percent. Note: these are federal rates only and provincial rates would be in addition to these.
What you should take away from the above is much like the ads that we hear from the government regarding gambling. Know your limits and play within them.
Typically, the role of passive income in private corporations is to build a tax efficient cash flow for the owner(s) future. The rules around owing capital gain producing investments makes owning these investments all the more critical in achieving long-term growth objectives and tax efficiency.
· A good solution for owners continues to be to own investments that have both quality income and above average potential for capital gains. Investments that do not pay shareholders income/dividends are typically in their growth stage and can have greater price fluctuation. The advantage of capital gains in a corporate account is that they will continue to be taxed at 50% of the gain. This keeps the tax logic in line with how capital gains are taxed for individuals.
· Earning strictly capital gains through passive income could potentially double the amount in bullet point 6.
· Using corporate class mutual funds may also be a good strategy given they can defer most sources of income. But you can give up performance given their fees, and CRA removing the ability to switch between different funds without triggering capital gains. Know what you are doing before you venture into this space.
· Owning mutual funds and ETF’s have an issue called “imbedded capital gains” that could be negative for corporate and cash accounts. If you and your advisor aren’t aware of the potential problems with imbedded capital gains, time for you both to do some homework.
· Upon reaching the $50,000 passive investment income threshold, consider investing corporate dollars into a corporately-owned, tax-exempt permanent life insurance policy with cash value. In addition to preserving the small business deduction, this type of life insurance policy can be used for the following purposes:
o Financial protection
o Reduction of Personal Income Tax
o Creating tax-efficient personal or corporate cash-flow
o Maximizing an estate
Knowing how to maximize your results is paramount to having the after-tax income you planned for when you want it. Making sure that both your accountant and investment advisor are on board will definitely go a long way in making that happen. There is still some low hanging fruit out there, you just need to know where to go picking.