Over the last few years, a number of fundamental changes have been made to the way private corporations and their shareholders are taxed. Some of these changes affect a wide range of taxpayers and are complex and difficult to understand, even for tax professionals. One major change that has been widely discussed is the expanded legislation regarding what was commonly known as “kiddie tax”—now known as the tax on split income (TOSI). The new legislation further limits the circumstances wherein income can be split between family members who are subject to lower marginal personal tax rates.
In addition to TOSI, two other measures were enacted in 2018 to limit the tax deferral benefits when investment income is earned in a private corporation:
- Limiting access to the small business deduction; and
- Limiting access to refundable taxes.
These two measures are not mutually exclusive and can apply simultaneously. They are effective for year-ends beginning on and after January 1, 2019.
Limiting access to the small business deduction
In BC, up to $500,000 of active business income earned by an associated group of Canadian-controlled private corporations (CCPCs) is subject to a combined federal and provincial small business tax rate of 11% for 20191—quite a favourable rate compared to the general corporate tax rate of 27%. The new measures introduce a grind to the small business limit of $500,000 in cases where an associated group of CCPCs has earned $50,000 or more of adjusted aggregate investment income (AAII) in the previous taxation year. For every $1 of AAII earned above the $50,000 threshold, the small business limit will be reduced by $5. When AAII reaches $150,000, the small business limit will be ground to nil.2
Under the new legislation, AAII generally includes, but is not limited to, the regular categories of investment income, such as interest, rent, royalties, and portfolio dividends. It also includes taxable capital gains from the disposition of passive investments. Conversely, the calculation of AAII excludes taxable capital gains from the disposition of assets used in carrying on an active business, rent or interest received from an associated corporation that is classified as active business income, and dividends from connected corporations.3 Bottom line: It appears that the government wants to encourage small businesses to reinvest profits into their active businesses, rather than into passive investment holdings.
Businesses that earn passive investment income in a corporation may want to consider the following strategies to minimize the impact of the small business grind:
- Ensure expenses such as interest expense and management fees are properly allocated to reduce AAII below the threshold; and
- Increase investment income, such as gains on passive investments, in years where a lower amount of active business income is earned.
Limiting access to refundable taxes
To understand the policy intention behind this measure, it may be helpful to review the concept of integration in the Canadian income tax system. In our tax system, integration means that the total amount of combined taxes paid by a corporation and its shareholders on income earned through the corporation will be, ideally, equivalent to the taxes paid on the same income earned directly by an individual. The mechanism of how this is achieved varies between different categories of income: active business income subject to the small business rate, active business income subject to the general rate, and passive investment income in a CCPC.
Active business income earned by a CCPC is subject to either the small business rate of 11% or the general rate of 27% in BC, depending on the circumstances. If the income is subject to the general rate of 27% tax in the corporation, the corporation will accumulate what is known as a general rate income pool (GRIP) account from which eligible dividends can be paid if there is a sufficient balance. In the hands of individual shareholders, eligible dividends are subject to a lower tax rate than non-eligible dividends.
Passive investment income earned by a CCPC is subject to a different taxation mechanism than active business income. In BC, passive investment income is taxed at a high corporate tax rate of 50.67%, which includes a refundable portion of 30.67%. This refundable portion is added to the corporation’s refundable dividend tax on hand (RDTOH) account. When the corporation pays taxable dividends to its shareholders, it receives a tax refund from its RDTOH account.
This mechanism ensures that investment income earned through a corporation does not result in any tax deferral benefits. The income is taxed up front at a rate of 50.67%, and the corporation can only claim a refund when taxable dividends—on which the shareholders will be subject to income tax—are paid.
Before these changes were introduced in 2018, corporations were entitled to receive a refund from their RDTOH accounts as long as taxable dividends were paid, regardless of whether or not the taxable dividends were eligible. This means that a corporation could, technically, receive a refund from its RDTOH account (generated from earned investment income) by paying eligible dividends from its GRIP account (generated from earned active business income, subject to the general tax rate). If a corporation only earned investment income, the RDTOH could only be refunded by the payment of a non-eligible dividend. Ultimately, this mismatch could result in a deferral of personal taxes of approximately 10.5% in BC for 2019.
The government identified this mismatch, and its new measure eliminates this deferral advantage by introducing two separate RDTOH pools: eligible (ERDTOH) and non-eligible (NERDTOH). Essentially, the ERDTOH pool will accumulate when a corporation earns eligible portfolio dividends or eligible dividends paid by connected corporations, such as wholly owned subsidiaries (to the extent that the payor corporation received a refund from its own ERDTOH pool). The remainder of the refundable taxes generated from regular investment income, such as interest, rent, royalties, and capital gains, will be added to the NERDTOH pool.4 Payment of eligible dividends can only result in a refund from the ERDTOH pool. A payment of non-eligible dividends will result in a refund from the NERDTOH pool first, before a refund can be obtained from the ERDTOH pool, if applicable.5
A transitional rule is in place to determine how to allocate the existing RDTOH balance between the two separate accounts. For CCPCs, the balance to be added to the ERDTOH pool will be an amount equal to 38.33% of the GRIP balance, up to the corporation’s existing RDTOH balance. The remaining RDTOH balance, if any, will be allocated to the NERDTOH pool. For non-CCPC private corporations, the existing RDTOH balance will be added to the ERDTOH pool.6
Private corporations should consider the following strategies to track their ERDTOH and NERDTOH accounts, applicable for tax years starting before January 1, 2019:
- In a stacked corporation structure, ensure that a sufficient GRIP balance coincides with the RDTOH balance in the same corporation so that the transitional rule applies when it comes time to allocate all or a portion of the existing RDTOH balance to the ERDTOH pool; and
- For CCPCs with a high GRIP but low RDTOH balance, consider triggering passive investment income or gains to preserve a higher balance in the ERDTOH pool.
The new changes reduce the deferral advantages for businesses that use the after-corporate-tax profits realized from earning active business income to earn passive investment income in a private corporation. This is due to both the impact of earning passive investment income on the small business limit and the new categorization of refundable dividend tax accounts. However, it is also important to recognize that where excess business profits are earned through a corporation, tax can be deferred simply by maintaining these funds in the corporation.
To preserve a corporation’s ability to pay eligible dividends to obtain a refund from its existing RDTOH account, careful planning should be done for a year-end that started prior to 2019. On an ongoing basis, careful planning can also lessen the grind to the small business limit in future years.
Tina Huang is a senior manager in tax at BDO Canada LLP in Vancouver, where she specializes in personal and corporate tax planning for privately held businesses and high-net-worth individuals, as well as corporate reorganizations, purchases and sales of a business, and estate planning. She thanks Tara Pedersen, CPA, CGA, senior manager in tax at BDO, for her assistance with this article.
- ITA 125(1).
- ITA 125(5.1)(b).
- ITA 125(7).
- ITA 129(4).
- ITA 129(1).
- ITA 129(5).