2018 FEDERAL BUDGET
This afternoon, Finance Minister Morneau tabled his third Budget. After taking on the small business community and tax professionals across the country since his proposals of July 18th, 2018, he appears to be listening.
He has not taken any steps to change the rules related to the ability of taxpayers to split income through the payment of dividends to “non-active” family members, nor was any change expected. He still insists that the Government will move ahead with their “simplified” measures concerning income splitting. See my newsletter of December 22nd discussing the new rules and their “simplicity”.
Although there is nothing in this Budget to reduce that litigation, Canada’s federal courts, including the Tax Court of Canada, will receive $41.9 million over five years, and $9.3 million per year on an ongoing basis.
There are some tax measures that are nice election platforms – the introduction of the Canada Workers Benefit, improving the Canada Child Benefit and a lot of discussion about gender equality. There are improvements in paternity benefits.
Not to discount the importance of these measures, most readers are interested in the corporate and business tax changes.
One big positive in this Budget is additional support for the Courts. As I have stated in past newsletters, both the current and previous Chief Justices of the Tax Court have stated that the Court is over-burdened and will be unable to cope with the litigation that will be generated by the July tax proposals. Although there is nothing in this Budget to reduce that litigation, Canada’s federal courts, including the Tax Court of Canada, will receive $41.9 million over five years, and $9.3 million per year ongoing, to the Courts Administration Service.
Tax Evasion and Tax Avoidance
As has been the case in many Budgets in the last few years the Government has made the usual statements about cracking down on tax evasion and avoidance, with the emphasis on international tax avoidance.
Increased Reporting Requirements For Trusts—Beneficial Ownership
Better information on who owns which legal entities and arrangements in Canada—known as “beneficial ownership information”—will help authorities to effectively counter aggressive tax avoidance, tax evasion, money laundering and other criminal activities perpetrated through the misuse of corporate vehicles.
To improve the availability of beneficial ownership information, the Government proposes to introduce enhanced income tax reporting requirements for certain trusts to provide additional information on an annual basis, applicable for the 2021 and later taxation years.
In December 2017, federal, provincial and territorial Finance Ministers agreed in principle to pursue legislative amendments to their corporate statutes to require corporations to hold accurate and up-to-date information on beneficial owners, and to eliminate the use of bearer shares.
The Government proposes to introduce legislative amendments to the Canada Business Corporations Act to strengthen the availability of beneficial ownership information.
Holding Passive Investments Inside A Private Corporation
The most controversial provision of the earlier proposals were the proposals for dramatically increasing the tax paid on passive investment income earned in private corporations. I have discussed these rules numerous time, including my posting of November 3rd, 2017.
The rules originally proposed would have entailed untold complexity – it was estimated by one tax expert who was formerly a legislative draftsman at the Department of Finance that the new rules would require 100 pages of legislation.
To give the Government its due, the rules included in the Budget are a huge departure from the rules originally proposed and are certainly better for taxpayers. As Dan Kelly, President of the Canadian Federation of Independent Business, has said, the new rules included in the Budget are “less bad” for small business than the previous proposals.
The former rules would have increased the tax rate on investment income when it was paid out to shareholders to as much as 73%.
Clearly the Minister of Finance has been listening.
As discussed in my previous posting, passive investments already made by private corporations’ owners, including the future income earned from such investments, will continue to be taxed under the existing rules. This still raises huge complexities in determining what income and capital will be included. The other problem is that this protects “old money” at the expense of younger entrepreneurs trying to build capital.
It is suggested that incentives will be maintained such that Canada’s venture capital and angel investors can continue to invest in the next generation of Canadian innovation.
With a view to reducing the complexity that would have been in the original proposals, the Government proposes two new measures to limit deferral advantages from holding passive savings in a corporation.
Limiting Access To The Small Business Tax Rate To Small Businesses
The first measure proposes to limit the ability of businesses with significant passive savings to benefit from the preferential small business rate. The current small business credit limit allows up to $500,000 of active business income annually to be subject to the lower small business tax rate of approximately 15%. A group of associated companies share the $500,000 limit. Business income in excess of this amount is taxed at approximately 26.5%. Access to the lower tax rate is phased out on a straight-line basis for associated Canadian-controlled private corporations (CCPCs) having between $10 million and $15 million of aggregate taxable capital employed in Canada.
The original proposals would have removed the ability of a CCPC to claim refundable taxes in respect of its investment income, when that income is paid out to shareholders in the form of dividends, resulting in a huge increase in the combined corporate/personal tax rates. Rather than remove access to the refundable taxes as proposed in July 2017, an alternative approach is proposed to gradually reduce access to the small business tax rate for corporations that have significant passive investment income. This approach would ensure that the small business rate is targeted to support small businesses.
For those of us of “a certain age”, this is not a new concept. There used to be an account called the Cumulative Deduction Account which was an aggregation of accumulated low rate business earnings. When the account reached a certain level, originally $400,000, the access to the small business rate was lost. The account could be reduced, and thus access to the lower corporate business rate restored, by the payment of dividends to shareholders.
The Budget proposes to introduce an additional eligibility mechanism for the small business deduction, based on the corporation’s passive investment income. The previous Cumulative Deduction Account was based on accumulated low rate active business income.
Under the proposal, if a corporation and its associated corporations earn more than $50,000 of passive investment income in a given year, the amount of income eligible for the small business tax rate would be gradually reduced. Presumably this $50,000 threshold replaces the threshold of the same amount discussed in my earlier posting.
It is proposed that the small business deduction limit be reduced by $5 for every $1 of investment income above the $50,000 threshold (equivalent to $1 million in passive investment assets at a 5-per-cent return), such that the business limit would be reduced to zero at $150,000 of investment income (equivalent to $3 million in passive investment assets at a 5-per-cent return).
The proposal represents an important departure from the July approach. The rules now proposed do not directly affect taxes on passive investment income. The tax applicable to investment income remains unchanged—refundable taxes and dividend tax rates will remain the same, unlike the July 2017 proposal. One must assume that the ability to pay out tax free capital dividends will also not be changed.
The Government claims that existing savings will not face any additional tax upon withdrawal. However, under the new proposal, no investment income will be subject to additional taxes on withdrawal, so this statement is somewhat disingenuous.
Unfortunately, the Government claims that the new approach will not require the tracking of new and legacy pools of passive investments, and will target only private corporations with more than $50,000 in passive investment income per year. If the rules are to continue to “grandfather” accumulated savings, then tracking would be necessary.
Capital gains realized from the sale of active investments or investment income incidental to the business (e.g., interest on short-term deposits held for operational purposes) will not be taken into account in the measurement of passive investment income for purposes of this measure.
Limiting Access to Refundable Taxes for Larger CCPCs
The tax system is designed to tax investment income earned by private corporations at a higher rate, roughly equivalent to the top personal income tax rate, and to refund a portion of that tax when investment income is paid out to shareholders. This is the theory of “integration” which has been with us since 1972, and which the July proposals threatened to eliminate. It is designed to integrate the corporate and personal tax rates on investment income.
The second measure being introduced will limit the ability that certain CCPCs can obtain by accessing refundable taxes on the distribution of certain dividends.
In practice any taxable dividends paid by a private corporation can trigger a refund of taxes paid on investment income, regardless of the source of that dividend (i.e., whether coming from investment income or lower-taxed active business income).
The Budget proposes that CCPCs no longer be able to obtain refunds of taxes paid on investment income while distributing dividends from business income taxed at the general corporate rate. Refunds will continue to be available when investment income is paid out. This is actually consistent with the scheme of integration. Integration is not really designed to apply to active business income.
The two measures will apply to taxation years that begin after 2018. This marks a change from the original proposals which were to take effect on January 1st, 2018.
What about Holding Companies?
The rules originally proposed would have dramatically increased the tax burden on investment income earned in a private corporation, in some cases to a rate of 73%. The new rules do not change the taxation of investment income but target active business income by reducing access to the small business credit and removing the availability of refundable taxes when dividends are paid out of business income, as opposed to investment income.
For those taxpayers who do not carry on active business, it would appear that there is no adverse tax consequences related to passive investment income.
“A Good Retreat Is Better Than A Bad Stand”
This Irish saying sums up the changes in the rules relating to passive investment income earned in a private company. Make no mistake, the rules included in the Budget represent a major retreat on the part of Finance Minister Morneau. He has backed down almost completely regarding the manner in which investment income will be taxed.
In doing so, he has, perhaps, lived to fight another day.
Until we saw the Budget, most tax professionals were gearing up to continue the fight that we started on July 18th, 2017. That fight may yet continue, but not with as much force.
For now, Morneau has earned some degree of calm. Whether it is simply the calm before the storm remains to be seen.