Last updated: Oct. 18, 2017
Finance Minister Bill Morneau issued an announcement outlining how he intends to proceed with changes to how passive income earned in private companies is taxed.
This was seen by many as the most controversial feature of the original tax proposals and this announcement includes significant relief from these proposals that will benefit many private businesses.
Proposed Changes to Small Business Tax from July 18
Recall that the consultation paper is made up of 3 sections:
- Income Sprinkling
- Passive Investment Income Held by Small Business Corporations
- Converting Regular Income to Capital Gains
This latest announcement refers to the section on Passive Investment Income
Passive Investment Income
The current system allows for a tax deferral of the individual tax payable if the shareholder leaves funds in the corporation.
The government believes that this tax deferral results in a significant tax advantage to owners of private corporations.
- Assume a small business tax rate of 15% applies.
- An individual earning active business income of $100 in their private corporation would have $85 after-tax to invest passively if those funds are retained in the corporation.
- In contrast, if an individual earned the same $100 as salary, assuming they are subject to a high personal tax rate of 50%, they would have $50 after-tax to invest personally.
The government believes that the additional $35 of capital available to corporate owners to invest in passive investments when using a corporation results in a significant advantage that grows over time.
Maximum Threshold of Investment Income
The government intends to move forward with measures proposed on July 18 to limit the tax deferral benefits of passive investments in private corporations.
However, the government reinforced that it intends to balance this intention with its commitment to provide flexibility for small business owners.
Most significantly, they have announced a maximum threshold of $50,000 of investment income per year that can be earned in a corporation that will not be subject to the new regime as it will continue to be subject to the current refundable tax system.
The government estimates that this threshold represents approximately $1,000,000 in invested assets, using an assumed 5% rate of return.
There is no indication of how the $50,000 will be determined – for example, will the full capital gain on sale of securities be included, or 50% of such a gain?
This threshold is meant to provide flexibility for small business owners to hold savings for multiple purposes such as sick leave, parental leave, an economic downturn or retirement.
The government gave reassurances to business owners who have significant investments in passive assets in corporations that the new rules will apply to new investments only. That is, income earned on existing assets will not be affected.
The government is considering the appropriate scope of measures as they relate to capital gains, specifically whether capital gains realized on the sale of shares of a corporation engaged in an active business might be excluded from the new rules.
Draft Legislation Part of 2018 Budget
The government will release draft legislation as part of its 2018 federal budget. However, there is no indication of an effective date of the new proposals. Originally it was January 1, 2018.
Venture Capitalists and Angel Investors
The government also wants to ensure that incentives are maintained for Canada’s venture capitalists and angel investors.
The government will consult with the venture capital and angel investment sectors to identify how this might be best achieved.
Not Applicable to a Farmer’s AgriInvest Account
The government stated that it will ensure that the proposed changes to passive investments will not apply to income from AgriInvest.
No Effect for Small Business Owners with Less Than $50,000 Passive Investments
Small business owners can be assured of a safe-harbour amount of investment income.
Corporations with investments in passive assets that generate no more than $50,000 per year of investment income will continue to be taxed under the existing tax regime and will not be subject to the proposed new regime.
We will need to wait until the 2018 federal budget for further details on how income over that threshold will be taxed.
We are committed to keeping you updated on issues around the private corporation tax changes.
The government has planned additional announcements in the upcoming week to provide further details of changes that it intends to make in response to Finance’s recent public consultation on these controversial proposals.