New Tax Rules and New Tax Strategies with the Small Business Deduction

In 2018, the federal government passed new tax legislation impacting Canadian controlled private corporations (CCPCs). One new measure of particular concern is the potential loss of the small business deduction (SBD). For entrepreneurs, knowing what the new rules entail and creating strategies to maximize tax efficiency will help increase available cash to reinvest in the business and avoid pitfalls with the Canada Revenue Agency.

A CCPC has access to a significantly lower tax rate on the first $500,000 of active business income (the $500,000 threshold is known as the ‘SBD limit’). This allows the corporation to retain more after-tax funds to reinvest in the business.

Passive income earned by the corporation includes income generated from rental properties and income from investments such as marketable securities, including taxable capital gains and interest income. Passive income is typically taxed at higher rates than active business income in a CCPC, but incorporates a refundable tax that is returned to the corporation when taxable dividends are paid by the corporation to its shareholder(s).

The New Rules – Federal Government

Under the new rules, passive investment income earned by a CCPC can have a negative impact on the corporation’s ability to claim the SBD. For every $1 of passive income earned over the new $50,000 threshold by an associated group of companies, the SBD limit will be reduced by $5. Once passive investment income earned by the group exceeds $150,000, the ability to claim the SBD is eliminated.

The following table illustrates how the SBD is affected depending on the level of passive income earned by the associated group of companies and the amount of active business income earned each year:

These new rules can result in an increase in the amount of corporate tax paid by a business. However, income distributed as “eligible” dividends can mitigate the impact to the shareholders.

Ontario Will Not Parallel the Federal Tax Changes for the SBD

Currently, Ontario also provides a reduction in the tax rate to CCPCs that qualify for the SBD. This reducing the provincial tax rate for a CCPC situated in Ontario for its first $500,000 of active business income from 11.5 percent to 3.5 percent (the combined small business income tax rate for an Ontario CCPC is 12.5 percent for 2019). However, the former Ontario government announced in its 2018 Budget it would parallel the new rules announced by the federal government, resulting in the potential loss of the entire SBD for a CCPC that also earns investment income in excess of $50,000.

However, subsequent to the 2018 provincial election, Ontario confirmed its commitment to helping small businesses and cutting taxes and will not be following the changes announced in the federal measures with respect to the claw-back of the SBD. This change has a significant impact, as the bulk of the small business deduction’s corporate tax savings is provincial (currently $40,000 out of $70,000 in Ontario).

Furthermore, the loss of the SBD at the federal level allows the corporation to add its after-tax earnings to its General Rate Income Pool (GRIP) balance. Taxable dividends paid by the corporation can either be designated as “eligible” or “non-eligible” dividends. Eligible dividends received by an individual attract tax at significantly lower personal tax rates. A corporation typically can only pay eligible dividends if it has a sufficient GRIP balance.

As a result of Ontario’s decision not to parallel the federal measures relating to the SBD, a shareholder of an Ontario CCPC may benefit on an overall net basis. Although the corporation may incur a slightly higher corporate tax cost, the individual will pay less tax on the receipt of eligible dividends from the company.

Example: A CCPC in Ontario earns $500,000 of active business income in 2019. The CCPC is associated with another company that earns more than $150,000 of investment income during the year. Under the new rules, the CCPC will pay corporate tax in Ontario at 18.5 percent, as it loses its SBD federally but not in Ontario.

As a result, the CCPC pays $92,500 of corporate tax. The corporation pays out all of its after-tax earnings as an eligible dividend to the individual shareholder, attracting personal tax at the top marginal rate of 39.34 percent. The individual retains $247,189 after paying personal level tax.

Contrast this with a CCPC with the same amount of active business income in 2019 but does not have its SBD reduced as it does not earn any passive investment during the year. This corporation will pay $62,500 of corporate tax in Ontario at the small business tax rate of 12.5 percent. If the corporation pays out all of its after-tax earnings as a non-eligible dividend to its individual shareholder, attracting personal tax at the top marginal rate of 47.40 percent, the individual retains only $230,125 after taxes (a difference of $17,064 compared to the individual of the first CCPC).

New Strategies

To preserve the small business deduction limit under the new rules, it may be necessary to review the investment strategy for the company to better manage the timing and types of investment income earned by the corporation. Other strategies to consider include increasing salaries paid by the investment business, reorganization the business, and the acquisition of a life insurance policy.

However, with Ontario failing to parallel the federal measures, it may not be necessary to take any action as the integrated result to the shareholder of the CCPC may be advantageous.

Although there is significant concern in the business community with respect to the new rules, there are still effective strategies and options available to manage and reduce the overall tax costs. Meet with a trusted professional to determine what and if any changes should be made to your corporate structure to minimize your tax exposure and optimize tax opportunities.

For more information, contact Bruno Lucente, CPA, CA, at 416.515.3807 or [email protected]or Jeanne Cheng, CPA, CA at 647.775.1768 or [email protected].