Impact on the Small Business Deduction
By Maninder Dhadda, CPA, CGA
Maninder Dhadda is a senior tax manager at Smythe LLP in Vancouver. He specializes in Canadian taxation and primarily focuses on advising the shareholders of privately owned companies with regard to their Canadian corporate and personal income tax planning and compliance matters. Maninder would like to thank Tom Morton, CPA, CA, a tax partner at Smythe LLP, for his advice and guidance on this article.
Note to readers: The consultation paper described in this article generated considerable concern among many in the profession in the summer and fall of 2017. To review CPA Canada’s response to the proposed legislation, visit the Members’ Area of the cpacanada.ca website and choose “Taxation of private corporations” under News from the profession. As of this writing, the latest update was made on May 16, 2018.
On July 18, 2017, Canada’s Department of Finance released a consultation document about the use of tax-planning strategies involving private corporations. The government’s stated intention in releasing the document was to increase the fairness of the tax system, which is foundational to the Income Tax Act (ITA). At issue was the perception that private company owners can accumulate investment wealth faster than employees earning the equivalent income—specifically, that private companies taxed at lower tax rates than individuals can use these tax savings to accumulate passive investments rather than reinvesting the after-tax earnings in their business to stimulate growth, create more employment, etc.
The consultation document proposed three possible solutions to this perceived inequity, which amounted to three very complex—some would say unworkable—proposals to levy additional income taxes on any passive investment income earned by private companies. Several months of consultation followed. Then came the release of the February 27, 2018, Federal Budget and accompanying Notice of Ways and Means Motion, which included substantive tax changes to reduce the perceived advantage to private corporations holding passive investments.
The proposed new tax rules differ from those in the July 2017 consultation document in that they do not directly levy additional income taxes; instead, the government proposed changes to the ITA that would limit deferral advantages to private corporations “in a more targeted and simpler manner."1
The Proposed New Rules
Under the legislation proposed on February 27, 2018 (the proposed legislation),2 a corporation and its “associated corporations”3 that earn more than $50,000 of passive investment income in a year will find their access to the small business deduction (SBD)4 reduced.
To understand the mechanics of how passive investment income grinds down the SBD, a brief refresher of the SBD rules may be helpful. At its simplest, the SBD is a credit against income taxes otherwise payable by a Canadian-controlled private corporation (CCPC)5 that reduces the combined federal and BC corporate income tax rates from 27% to 12% (2018 rates) on the first $500,0006 of the CCPC’s income from “active business”7 carried on in Canada. The $500,000 SBD business limit is shared among associated corporations.
Under the existing legislation, the $500,000 SBD business limit for a particular taxation year is reduced if the CCPC or associated CCPCs’ “taxable capital employed in Canada”8 in the preceding taxation year exceeds $10 million. If the taxable capital employed in Canada in the preceding taxation year reaches $15 million, the limit is ground to $0.9
The proposed legislation would reduce the $500,000 SBD business limit by the “adjusted aggregate investment income” (AAII) earned by the CCPC or associated CCPCs in each taxation year ending in the preceding calendar year. (Note that this is a proposed amendment to the definition of “business limit reduction” in Subsection 125 (5.1) of the ITA, as the reference to the preceding calendar year with respect to AAII is slightly different than the reference to the preceding year for “taxable capital employed in Canada.”10) The formula would permit a company to earn $50,000 in passive investment income without triggering a grind to its SBD business limit. This means that the $500,000 SBD business limit would be reduced on a straight-line basis from $500,000 to $0 if the CCPC and its associated CCPCs earned between $50,000 and $150,000 AAII in the preceding calendar year.11
As a formula, this 5-to-1 reduction of the $500,000 SBD business limit reflects the government’s desire to drastically curtail a private corporation’s ability to use the tax savings from the SBD to accumulate passive investment assets.
Critical to understanding the proposed reduction of the $500,000 SBD business limit is understanding the calculation of AAII.12 Under the proposed legislation, AAII is equal to a CCPC’s “aggregate investment income” (AII)13 for the year, with the following adjustments:
- Dividends from non-connected14 corporations, and
- Income from savings in a life insurance policy that is not an “exempt policy”15 to the extent that it is not included in AII.16
- Taxable capital gains (and losses) from the disposition of:
- Property used principally in an active business carried on primarily in Canada by the CCPC or by a related CCPC,17 and
- Shares of a connected CCPC, where all or substantially all of the fair market value of the connected CCPC’s assets is attributable directly or indirectly to assets that are used principally in an active business carried on primarily in Canada; and
- Net capital losses carried over from other taxation years.
The grind to the $500,000 SBD business limit would be the greater of the reduction resulting from taxable capital employed in Canada in excess of $10 million or the reduction for AAII in excess of $50,000.
Some commentary about the application of the rules for the proposed reduction of the $500,000 SBD business limit suggests that the new rules would apply to taxation years commencing after 2018, but that is not quite correct! It’s true that the reduction of the $500,000 SBD business limit would apply for taxation years commencing after December 31, 2018. However, if a company has a December 31 year-end, the grind in the $500,000 SBD business limit will be based on the AAII of the fiscal period or periods of the company in the 12 months ending December 31, 2018—this means we would need to be cognizant of the new rules when doing tax planning for 2018. If, however, a company has a November 30 year-end, its first fiscal year-end commencing after December 31, 2018, will be November 30, 2020—this means the tax planning for the grind to the $500,000 SBD business limit would not be an issue until the planning occurs for its year-end or year-ends occurring in the 12-month period ending November 30, 2019.
Contrary to statements made by the government and the Department of Finance during the consultation process in July and September 2017, there are no rules in place to grandfather the earnings of passive investments held by a private company before the proposed change in tax law takes effect. Aside from the exemption of the first $50,000 of AAII, which by the government’s own admission equates to earnings on $1 million of passive investments, there is no recognition of or accommodation for the fact that private company owners need to accumulate investments in their companies as a safety net for economic slowdowns and as pension for when they retire.18
The government said it expects that 3% of companies currently claiming the SDB would be affected by the proposed tax rules.19 If that is indeed the case, it seems like the government is using a sledgehammer to swat a fly.
1 Department of Finance Canada, Equality + Growth: A Strong Middle Class (Budget Plan), 2018 (page 73).
2 The proposed legislation, Bill C-74, had its first reading on March 27, 2018.
3 ITA, Part XVII, Subsection 256 (1).
4 ITA, Subdivision B, Subsection 125 (1).
5 ITA, Subdivision B, Subsection 125 (7).
6 A CCPC’s business limit for a taxation year is $500,000. The $500,000 business limit is shared among associated CCPCs, pursuant to Subdivision B, Subsection 125 (2) of the ITA.
7 ITA, Subdivision B, Subsection 125 (7).
8 ITA, Part I.3, Section 181.2.
9 ITA, Subdivision B, Subsection 125 (5.1).
10 The wording with regard to AAII addresses the possibility of a company having multiple year-ends in the preceding calendar year to reduce the earnings in the last year-end of the prior year, thereby reducing the grind to the SBD business limit. This wording is not needed for the grind to the SBD business limit because “taxable capital employed in Canada” is a balance sheet item.
11 The 5-to-1 reduction means that there will be a $5 grind in the SBD limit with every $1 of passive investment income over $50,000 earned by the CCPC.
12 This is a proposed amendment to Subdivision B, Subsection 125 (7) of the ITA.
13 ITA, Division F, Subsection 129 (4). Previously, the definition of aggregate investment income was relevant only for calculating the amount of dividend taxes.
14 Pursuant to ITA, Part IV, Subsection 186 (4): A payer corporation is connected with a CCPC if it is controlled by the CCPC or if the CCPC owned more than 10% of the issued share capital, having full voting rights and with a fair market value (FMV) of more than 10% of the FMV of all of the issued share capital of the payer corporation.
15 Defined in ITA Regulation 306. It is very rare for a life insurance policy in Canada not to be an “exempt policy.”
16 If a life insurance policy is not an “exempt policy,” the income would already be in AII by virtue of the income inclusion rules, pursuant to ITA 12.2 (1).
17 Note that this does not extend the definition to “associated” CCPCs.
18 Although the owner of a company can participate in a Registered Pension Plan (RPP) as defined in Regulation 8515 of the ITA—otherwise known as an Individual Pension Plan—the retirement benefits available under such an RPP are less than the benefits available to an employee, and are far less than the amount available to an employee of the federal government.
19 Department of Finance Canada, Tax Measures: Supplementary Information, February 27, 2018.