An overview of the modified tax changes affecting private corporations

By: Vanito Pobran, CPA, CA, CFP, Wealth Planning Group

On February 27, 2018, the federal government tabled its much-anticipated 2018 budget. The budget put to rest much of the uncertainty regarding proposed changes to the taxation of private corporations, initially released for consultation on July 18, 2017. In response to concerns raised by Canadian taxpayers, the Department of Finance provided modified changes that will affect business owners using private corporations. The recent changes can be split into two main categories:

•Taxation of passive investment income; and
•Tax on split income

Taxation of passive investment income

After initially including proposals that could have potentially seen passive investment income earned in a corporation taxed in excess of 70% overall, the Department of Finance took a much more measured approach to addressing what it deemed as an “unfair” tax deferral available to private corporations.

Under the new rules, private corporations, together with their associated corporations, can earn a total of $50,000 of Adjusted Aggregate Investment Income (AAII) with no change from the current form of taxation. AAII is essentially a corporation’s taxable investment income, with a few adjustments for specific items as outlined in the legislation. The $50,000 threshold was chosen as it is equivalent to earning a 5% rate of return on a $1,000,000 investment portfolio. Once a private corporation’s AAII exceeds $50,000, the corporation’s small business deduction in the next year would be reduced at a rate of $5 for every $1 of passive investment income earned. Once a corporation has reached $150,000 of AAII, the small business deduction would no longer be available and the corporation would be subject to the high corporate tax rate on all income earned.

In addition, the budget proposed to change the mechanics of the current refundable tax levied on investment income, referred to as “refundable dividend tax on hand” (RDTOH). RDTOH arises on corporate investment income and can be recovered when taxable dividends are paid. Previously, a corporation could recover all RDTOH with the payment of an eligible dividend, which is subject to a lower personal tax rate, or a non-eligible dividend, which is subject to a higher personal tax rate. Budget 2018 proposes to replace the current RDTOH mechanism with two separate pools, eligible RDTOH and non-eligible RDTOH.

Eligible RDTOH will contain refundable tax arising from a corporation’s receipt of eligible portfolio dividends, and can be recovered by the corporation when eligible dividends are paid out to a shareholder. The non-eligible RDTOH pool will contain refundable tax on all other sources of investment income and can only be recovered by the corporation when non-eligible dividends are paid.

If you have a corporation or an associated group of corporations that is accumulating significant investment assets, these changes could affect you. There are a number of planning strategies that could be explored to redirect surplus corporate cash flow to minimize the effect of these changes.

Tax on split income

As expected, the government announced its intention to move forward with proposals for tax on split income (TOSI) and released a third version of the proposals as of March 22, 2018. In short, the rules seek to expand what was previously known as the “kiddie tax” in order to prevent private corporations from paying a spouse or adult child dividends on shares unless the recipient meets newly introduced exemptions or the amounts paid are deemed to be “reasonable” for work performed or capital contributed.

The proposed rules are complex and should be carefully considered by anyone using a private corporation.