I want to start by thanking the readers and others who have asked some excellent questions about details of the new rules on passive investments for Canadian small businesses and professional corporations.
I have spent some time reading commentary from various tax specialists. Discussing some specific nuances with professionals. And digesting – these rules give me heartburn.
The high-level description of the new passive investment income rules for small business was described in The Night-King Delivers His Budget. Basically, you want your active income and passive investment income to put you in the yellow zone below. [Updated Nov 2019 with an orange zone for NB & ON who decided not to mirror this tax change and reducing the impact].
You won’t be deported if you stray outside of the yellow, but you will pay more tax.
That would be very patriotic. Canada needs you to “do just a little bit more” to fund the Canadian Royal Family when they vacation. Er… I mean conduct business trips around the world.
Today, let’s flesh out a few of the nuances of the new passive investment income rules for small business. If you are masochistic or speak fluent accountant (a language similar to Klingon), then the full government tax measures supplement is here and the part you want is pages 17-29.
Since we are talking details today, the Federal budget puts this sliding threshold in place for the Federal portion of the small business tax (9.5%). Most provinces automatically tie their thresholds to the federal one, but some do not. I made the chart above assuming that provinces will use the Federal Threshold, but that is still not clear. For example, Saskatchewan currently has a $600K threshold for their 2% tax. It won’t make a large difference conceptually, since most of the small business tax is small except in ON, PEI, and PQ.
How is passive investment income going to be calculated?
This is a key concept since it determines the active business income threshold starting in calendar 2019. Active business income is your income from operations (or clinical practice in the case of doctors). To keep it really simple [sarcasm] passive investment income for this sliding tax scale is going to be called… Adjusted Aggregate Investment Income
What Counts as Adjusted Aggregate Investment Income?
Canadian and foreign dividends count.
This would be at their actual value (no gross up – that is for personal taxes). For foreign dividends, I am not sure how foreign witholding taxes will be accounted for. I suspect that the dividend net of witholding taxes would be used. We do get a full or partial refund of some foreign witholding taxes depending on tax treaties that Canada has with the witholding country. The effect of this is likely small for most people (15% of U.S. dividends and 8-10% for most other developed countries), but hey we are talking details here.
Interest from investments count.
The taxable portion (50%) of capital gains from investments count.
It is good that only the taxable portion is counted. That means $100K of realized capital gain would only count as $50K of passive income. However, there was also a nasty little nugget implanted. “Net capital losses from previous taxation years will be excluded“. Previously, if you had realized a loss in a prior year, you could carry that forward and deduct it from a future gain. I have not seen anywhere that that has changed in terms of how much tax you pay. However, you cannot apply those losses to keep you under the new income threshold.
That is kind of nasty. For example, if you had a $100K realized capital loss a couple of years ago, then the taxable part ($50K) could be applied against the taxable part of a gain in 2019.
Let’s say you realize a $200K capital gain in 2019 which means a $100K taxable gain. You could apply the previous $50K loss to reduce that $100K to $50K to pay tax on, but you would still have $100K of passive income bumping down your permitted active income.
If you have some carried forward losses and some unrealized capital gains, you may want to consider whether to realize some of those. This could give you a fresh start for the new rules in 2019 as long as you have enough losses to write them off in 2018. If you don’t have losses to write off, then realizing capital gains could just mean a bigger tax bill. I suggest consulting your tax professional – they are like underwear – don’t leave home without it.
What does not count as Adjusted Aggregate Investment Income?
Interest from short-term bank deposits that are used for operational purposes do not count.
Realized capital gains from an asset used in the business do not count.
For example, let’s say you own the clinic in which you practice and make money selling it. Doesn’t count for the passive income threshold.
Realized capital gains from selling a share in another CCPC that is connected to your CCPC where all or almost all the assets are from an active business do not count.
What constitutes a related or associated CCPC can be complex, but basically it is when two corps have the same owner(s) or are related to the owner(s) and have to share the small business tax threshold.
“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”. This means that if say you have a corp for your active business (OpCo) and one for your investments (HoldCo), that the passive income from both counts towards the thresholds for your OpCo.
What may or may not count – Insurance?
Exempted insurance policies do not count.
Most life insurance with ancillary investment aspects in Canada, like Whole or Universal Life Insurance are structured to be exempt and do not count towards the passive income cap. However, there were law changes in 2016 to make policies used primarily for investment slightly more restricted in the amount of investment component allowed. Manulife has a full summary of exempt insurance policies.
“Income from savings in a life insurance policy that is not an exempt policy will be added, to the extent it is not otherwise included in aggregate investment income.”
This means that Annuity Payments count.
Segregated funds count.
Are Investment Costs Deductible Against Investment Income?
There is nothing that I have found in writing. Presumably, the value used for passive investment income will be determined by adding up all of the above included-income. Then, subtracting deductible investment costs to give a net passive investment income.
What is normally deductile?
- Interest on investment loans is deductible.
- A fee-based or fee-only portfolio manager or investment advisor would be deductible for the portion of the fee applying to your corporate accounts.
- The fees for your taxable personal investment accounts would apply against your personal income (effectively giving you a discount at your highest marginal tax rate).
- Indirect fees, like commissions or management fees buried in ETFs or mutual funds are not deductible.
- Fees for financial planning not related to investment are not deductible.
- Subscriptions to financial newsletters etc are not deductible.
Hopefully, I have helped translate some of the finer details for those who are interested in such.
If you have other information to add or questions, please post in the comments below. I am not an accountant – I am a doctor. However, I will do my best to answer and consult experts when unsure. That said, you will want to work with your tax experts on this. The information may change or become more clear as this evolves. I will try to update the post accordingly.