Approaches for adapting to new corporate investment tax laws
By Josh Proulx, Tax and Business Succession Specialist, ATB Wealth, ATB Investment Management Inc. 2 January 2020 4 min read
Many business owners have historically been advised to invest excess business profits within their corporations to avoid personal taxes. This has been one of the most common ways for entrepreneurs to save for retirement and retain their hard-earned profits. In the summer of 2017, the federal government introduced new tax rules that may impact taxpayers with corporate investments, effective in 2019.
Here we provide an explainer on part of the new rules and some ideas for mitigating the impact.
Corporate investments have been a major planning opportunity for Canadian-controlled private corporations (CCPCs). Alberta CCPCs are taxed at a low rate of 11 percent on active business income in 2019, if they qualify for the small business deduction (SBD).
Until the corporation distributes its after-tax profit to its shareholders, there is typically no personal tax burden. Taxpayers would often defer their personal tax and invest their low-tax business profits in their corporations. This deferral advantage enables businesses to invest a larger principal until the shareholder needs the funds for personal use.
The deferral advantage is significant in part because of the low corporate tax rate on small business income. By having a low corporate tax burden, your company has a larger amount of after-tax funds with which to invest. In most cases, this low rate is available only on the first $500,000 of business income across your corporate group. Business income above that amount is taxed at 27 percent, more than double the small business rate.
The federal government is aware of this advantage and introduced several rules to limit its effectiveness. Historically, these limits prevented companies from multiplying their SBD and ensured that particularly large companies could not take advantage of the low rate. For corporate tax years that begin in 2019, however, there are two new restrictions to understand, one of which we will discuss here.
Under the new rules, your corporate group’s passive income can limit your access to the SBD. Ordinarily, each corporate group pays tax at 11 percent on the first $500,000 of active business income. Once the new rules come into effect, this $500,000 limit will be reduced, depending on the amount of passive income your corporations earned in the previous year. In most cases, every dollar of passive income above $50,000 reduces the limit by $5. Once your corporate group has earned $150,000 of passive income, the entire SBD will be unavailable for the next taxation year.
There is another new restriction that relates to how your corporation recovers its tax refund on passive income. Corporate passive income is taxed a high rate, but the Canada Revenue Agency grants a refund once the corporation pays dividends. This refund mechanism will be more complicated in future years. We have not described this in detail here, but you should discuss this with your advisor before your corporation’s next tax year-end.
If your company loses its SBD, it will pay tax at 27 percent on business income, rather than 11 percent. This may seem substantial, but this cost is not always detrimental.
In many ways, this is more of a prepayment of tax than a true increase. When business income is taxed at 27 percent, it enables your corporation to pay “eligible” dividends that are taxed at a much lower rate than typical “non-eligible” dividends. In other words, the combined corporate and personal tax burden on business income is fairly similar in either case, but a larger portion of the tax is payable upfront if the SBD is unavailable.
The true cost of losing the SBD is the loss of some tax deferral. Because more tax is paid immediately, there will be less after-tax profit available to invest or redeploy in the business. This may be a concern to some businesses, while others may be largely unaffected. For example, this change may not affect you if your corporate group only earns passive income. For businesses that are still active, you may wish to review your specific situation with both your financial advisor and accountant.
It is important that the “tax tail doesn’t wag the investment dog.” Changes to taxation of corporate investments can be significant, but there are several ways to manage it. If you are concerned about these changes, you should discuss some of the following solutions with your financial advisor:
- Tax-free withdrawals from your corporation: the value of investing through your corporation is to defer personal tax on the investment principal. If you can withdraw funds on a tax-free basis, it is usually more tax-efficient to invest personally. Two common ways to withdraw funds from your corporation tax-free are through repayment of shareholder loans or the distribution of your company’s capital dividend account.
- Individual Pension Plans: an individual pension plan(IPP) is a defined benefit pension plan you can create within your company for the benefit of one or more employees. Your company’s contributions to the plan are tax-deductible and are not subject to payroll taxes. In some ways, an IPP is similar to an RRSP, but you can typically contribute more to an IPP than you could to your RRSP. The IPP’s investment returns will be tax-deferred and should not con- tribute to your corporation’s passive income, so those returns should not typically reduce your SBD.
- Tax-exempt life insurance: life insurance is often overlooked as an investment vehicle. Though its main purpose is estate planning, whole life and universal life policies can also be used for tax-deferred investment within your corporation. These investment returns are tax-deferred, so they should not typically reduce your SBD.
Each of these alternatives (and others not discussed in this article) may enable you to find more tax- efficient ways to meet your investment goals. These alternatives also have a number of tax and non-tax considerations that your financial advisor can help navigate.