How to avoid paying more taxes for passive investment income?

In 2018, the federal government of Canada revised some rules that had a significant impact on Canadian-controlled Private Corporations (CCPCs). These revised rules will affect taxation years beginning after 2018. For companies with passive investment income more than $50,000, they may be required to pay more taxes in accordance with the new regulations. What can we do to avoid paying extra taxes? We offer you two strategies. But first, let’s understand what has changed.

What is an active business income and passive investment income?

Active business income usually refers to the primary and incidental income that a company receives from operating a business in Canada. Passive investment income, on the other hand, typically includes corporate earnings that are not directly related to these business sources. Passive investment income may include interest, capital gains, rents, royalties or dividends received by the company.

What has changed?

Currently, many Canadian-controlled private companies (CCPCs) use Small Business Deduction (SBD) to reduce corporate tax rates on their active business income. Usually, the small business tax rate is much lower than the general corporate tax rate. In Ontario, for example, the current tax rate for small businesses in 2019 is 12.5% ​​and the general corporate tax rate is 26.5%. The federal government has set the SBD limit to $500,000. In other words, for small businesses, the first $500,000 active business income will be taxed at a very favourable tax rate.

However, since the adoption of the new rules in 2018, when small businesses earn more than $50,000 in passive investment income, their Small Business Deduction limit will be reduced. Specifically, when the passive investment income exceeds the threshold of $50,000, every extra dollar earned on the passive investment income will reduce SBD limit by $5. When the passive investment income exceeds $150,000, the SBD limit will be reduced to $0. A CCPC can no longer enjoy the preferential tax rate.

What does this mean for small business owners?

To better understand the rules, let’s see the figure below:

The yellow area represents the preferential tax rate, and the gray area represents the general tax rate. Let’s assume the company is located in Ontario.

Case 1: Suppose a company has an active business income of $500,000 and a passive investment income of $50,000.

Under the old rules, the company will have to pay a tax of $50,000 X 12.5% ​​= $62,500.

Under the new rules, the company will have to pay a tax of  $50,000 X 12.5% ​​= $62,500.

The company continues to enjoy a preferential tax rate. The new tax rules have no impact on this case.

Case 2: Suppose a company has an active business income of $500,000 and a passive investment income of $100,000.

Under the old rules, the company will pay a tax of $500,000 X 12.5% ​​= $62,500

Under the new rules, the company will pay a tax of

1. $250,000 X 26.5% = $66,250
2. $250,000 X 12.5% ​​= $31,250

In total, the company will pay $97,500 in taxes, an additional $35,000 over the old rules.

Case 3: Suppose a company has an active business income of $500,000 and a passive investment income of $150,000.

Under the old rules, the company will pay a tax of $500,000 X 12.5% ​​= $62,500

Under the new rules, the company will have to pay a tax of $500,000 X 26.5% = $132,500,

In total, the company will pay $132,500 in taxes, an additional $70,000 over the old rules.

Please note that none of the above cases include taxes on the passive investment income itself. Once you have considered the passive income tax, you will quickly realize that the tax paid by the company may be close to or even exceed the passive investment income itself.

For example, in case 3, a passive investment income of $150,000 will be taxed at 50.17% or $75,300 in Ontario. Moreover, according to the calculation of case 3, the passive investment would also result in an additional $70,000 of tax on active business income. When adding these two together, the company will pay a tax of $145,300 or 97% of the $150,000 passive investment income. If the company is located in BC, it will pay a tax of $156,000 or 104% of the investment income.

Strategies

The more passive income you earn, the more taxes you will pay. So, what can we do to avoid paying extra taxes? In general, we have two options:

1. Withdrawing money from the company to buy RRSP / TFSA
2. Purchasing corporate-owned permanent life insurance policies

The purpose of the new rules is to encourage people to take money out of the company for investment; therefore, the government can collect more taxes. Obviously, the first option is the result that the government intends to achieve, but it may not be beneficial to small business owners.

If you still want to keep your investments in the company without paying more taxes, the better option is to invest in corporate-owned permanent life insurance policies. Under the current tax law, the investment proceeds from life insurance will not be counted as passive investment income; therefore, it will not affect the SBD limit. Companies can continue to enjoy the preferential tax rate up to $500,0000 in their active business income.

It’s time for a review

It is undeniable that passive investment income rules will bring new challenges to small business owners. In the meantime, it also creates an opportunity for you to review the company’s financial situation. Your accountant can help you with your tax planning. Your financial advisor can help you choose the most suitable product. It helps you evaluate whether corporate-owned life insurance can play a beneficial role in your company’s operations.

Disclaimer

All content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing in the site constitutes professional, legal, tax, investment, financial, insurance or other advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. For more information, please visit ApexLife.ca.