The Devils In The Details – What Counts In the Passive Investment Income Limits

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 and discussing some specific nuances with a professional wealth manager that I have started to collaborate with. He is remaining anonymous because we wanted it to be clear for everyone that our collaboration is purely to help physicians be better educated about their finances rather than as a way of promoting himself or his business. I connected with him because we share a passion for education and he has a similar way of looking at the tax bombs being tossed our way as challenges to be creatively overcome. It has been really stimulating and refreshing. We have no financial relationship. I am very grateful for his help, expertise, and insights. Having an external expert to bounce things off of for quality control certainly adds to the strength of what we are doing her at Loonie Doctor. So, I also wanted to say thank you for that.

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.

Note: I blurred out the kids and actor’s faces. They can’t help it and what kid doesn’t like to dress up like its Halloween.

You won’t be deported if you stray outside 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’s Wardrobe when they vacation, er… I mean conduct business trips around the world.

Today, we are going to spend some time fleshing 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.

They are going to use an 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.
  • 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.
  • 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.
    As Gholum says – nasty tricksy hobbitses…

    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 (as long as you have enough losses to write them off) in 2018 to at least start fresh for the new rules in 2019. I suggest consulting your tax professional – they are like underwear – don’t leave home without it.

  • “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 annuity payments count. Allocations from segregated funds 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. 
  • Investment Costs. There is nothing that I have found in writing, but presumably the value used for passive investment income will be adding up all of the above included income and subtracting deductible investment costs to give a net passive investment income. The cost of a fee based 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. Interest on investment loans is 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 and information may change or become more clear as this evolves. I will try to update the post accordingly.

18 comments

  1. Thanks for summarizing LD! Great detailed post.

    -However, there was also a nasty little nugget implanted. “Net capital losses from previous taxation years will be excluded“. –

    That is definitely a nasty little nugget! The government really has no qualms about stacking the cards in their favour eh? I guess this is targeting tax-loss harvesting as a strategy, as you can now only use it to deduct capital gains for that year and not carry it forward?

    DN

    1. Yes and no. I haven’t found anything about it affecting the actual tax paid on the capital gain. So you could presumably still use a loss to reduce the tax on a gain. However, it sure stacks the deck in favour of pushing people over their threshold into the red zone and more tax that way. Pretty tricksy.

  2. Advice for all Canadian docs- Start to really practice EXACTLY the way that you want. Running harder on the treadmill will likely be counterproductive. Thank you for the detailed outline Dr. LD. But hopefully from all this, it will help more docs realize that the best laid financial plans can fall apart quickly. We all need to learn to be nimble by taking care of the areas we can truly control- our personal expenses, our work schedules, our debt levels. If there is one truism that I have seen is that there is always change. Take time in your life to evaluate regularly if you can roll with any changes.

    I think I will chat with my accountant now….

    1. I 100% agree Dr. MB and thanks for your comment! You are cutting straight to the heart of why I am blogging about physician finances. I have recently been focused on technical details of planning, given the major changes happening and people’s anxiety around it. I am trying to show that there are many ways to financially adapt to them. However, behaviorally adapting is also vital. Money is just a two way exchange for time, effort, and some comfort/pleasures/experiences/security. If you don’t control your finances, or mistake money as the goal rather than the means to an end, then it will control you at the expense of those other priorities. Taking control of the areas you mention is key and gives you better capacity to adapt to the inevitable hiccups. One benefit of these sharply progressive tax raises over the past few years is that it did give me pause to re-balance by scaling back work in some areas. The time:money exchange rate shifted. I love my practice – I love it even more now that I practice exactly how and as much as I feel is optimal. I also have more time to focus on my other priorities – family, friends, and learning/building new things. I do look forward to getting back to writing about some of those (the fulfillment part of my blog logo).

  3. nice summary. If you limit passive income, then damage is controllable. The more I think about it, the more sense it makes to use swap ETF for bond, at the least.

    More good news, recent Ipsos poll shows federal conservative in lead.

    1. Thanks for your comment BC doc! There are so many ways to approach this. Swap-based ETFs are one option, but are relatively new products and have some risks (disclosure – I use HXT and HXX in my tax exposed higher growth/risk allocations of my portfolio). Another would be corporate class funds that largely convert income into capital gains and allow for tax-deferred return of capital to access cash while deferring realizing capital gains. They have higher mutual fund type fees, but also have a longer track record. I am planning a head to head comparison. Another approach is to pay a salary which both lowers active corp income (buying more passive income room) and also makes RRSP room. Putting the bond piece in the RRSP would be very tax efficient since it is sheltering income that would be taxed at full rate and paying that later, possibly at a lower rate (deferral and reduction). That would also allow room to focus capital gains, dividend payers, or growth allocations in other account types (Corp, TFSA, taxable) depending on the overall portfolio plan. I like the putting my eggs in multiple baskets approach to diversify against tax law change risk. Of course, if the bond allocation exceeds the room an RRSP would offer, then one may need other options and a swap ETF would be one. There are more approaches, but it will require full post(s) – currently in the cue.

  4. Question ?
    Would it make sense to purchase a rental property within the corp to diversify your investments. Would this income count as passive or active income.
    I understand problems start when one uses the property personally (the CRA assesses you for a taxable benefit on the personal tax side) or if you only rent it out for a few months and use it personally.
    Great blog
    Thanks

    1. Thanks for the question Jeff. Real estate in multiple forms could be a good alternative investment to diversify a portfolio. It requires a more sophisticated investor to do well at it. That is not me for real estate. Dr. Networth at http://www.drnetworth.com is knowledgeable.

      It is my understanding that you cannot hold real estate in a professional corp that is not ancillary to your practice. If you hold rental property in another corp with less than six employees, then it is considered a “specified investment business” and does not get the small business tax rate. I have given Dr. Networth the heads up on your question.

      1. Just adding my 2 cents to Jeff’s question. According to my accountant (who deals exclusively with physicians), having 1 (at most 2) rental property held in your MPC is “fine” in his opinion. However, if you are thinking of acquiring multiple rental properties, then you need to set-up a Holdco which then holds the rental properties through an additional Real Estate Holdco. So, it’s important to decide which path you want to take. I decided a few years ago to acquire multiple rental properties through Joint Ventures, so I set-up a Holdco and RealEstate Holdco.

        Rental income and capital gains from selling property (just like stocks) in a Holdco will be counted towards the $50k passive income limit. However, net rental income can be essentially reduced to zero through CCA (Capital Cost Allowance) “property depreciation”, but is recaptured when you sell the property. You are basically deferring the tax on rental income until later. For avoiding capital gains, refinance is a strategy to unlock the built-up equity in the rental property without paying capital gains. So, there are many tools available to bypass the $50k passive income limit when it comes to rental property.

        Hopefully this answers your question Jeff. I hope I didn’t scare you or anybody else away from thinking about purchasing a rental property via MPC/Holdco. There is a bit of a learning curve at the beginning, but it is definitely worth it for building long-term wealth, in my opinion.

        DN

          1. Add-on Question if you are willing…

            My corp owns the clinic in which I practice. There are some extra exam rooms, and a few other docs rent space from me. I pay for cleaning/snow removal etc…, everything a landlord would…

            Would these rental incomes be considered passive income? or ancillary to my medical practice? or something else?

            Thanks in advance.

          2. Hi Yoder. That is an excellent question! You should definitely check with your accountant, but my understanding (as a non-CPA) is the following. Being ancillary to the practice means that the real estate can be legitimately held in the corporation. Capital gains from it would be active income since it was actively used in the business. Rental income if you have under 5 full-time employees is usually considered passive investment income.

  5. On the bright side, I think most docs would be ok with 3 million in corporate savings generating 150 k of annual income. Add on cpp, non registered , tfsa and rrsp income and the numbers are even higher.

    The low ratio of doctors per capita in Canada will be a problem when doctors decide to
    1) stop working at 220 k after rrsp deduction as top marginal tax rates are insane (53.5 % Ontario)
    2) stop working in the red zone
    3) leave more difficult and stressful work
    4) take more vacations
    5) job share
    6) become cruise ship doctors
    7) move

    Jeff

    1. Thanks Jeff. I agree that with a range of tools docs can put together a decent passive income portfolio moving forward. It will be trickier for those who are close to retirement with all their eggs in the CCPC basket, but I have some ideas for those folks too.

      One positive for physician health that may come out of the series of cutbacks and tax hikes is that it may give some docs pause to evaluate and choose a better work life balance. It has for me & I am happier for it. I am on a three week vacation and it won’t be my last this year. Gotta take this time with my kids while they are still young enough to think vacationing with me is cool 😎

      1. I hear you LD. We are on the same page.

        I gave up my shifts this coming August to my partners, so that I will have the whole month off for an extended family vacation trip to Asia. I started giving up shifts (locums) to my partners last year to have more time off, and it’s been great! Happier and healthier.

        I must say that it felt weird (self-guilt) giving up shifts at first at my age, but now that I’ve started to scale back, it feels “normal” now to have all this time off.

        1. Way to go! That sounds great. It is funny how easy it is to fill the time off medicine, but was an adjustment for my family and I. Now if I work two busy weeks of call in row, we really feel it while before that was totally normal.

  6. Good discussion. want to check if my assumptions are correct under the new rules.
    1) If one doesn’t qualify for SBD, (combination of passive/active income), do you pay the higher rate for current year on the amount exceeding (not the whole amount)? and you won’t lose qualification for CCPC SBD next year (so recalculate again based on passive/active mix)?
    2) I can see how one can accumulate a high 7 figure portfolio and still have some room for contribution (7-8M with 1.5% net yield for 110K passive income, leaving 150-200K space), but with a large capital gain. Does the new rules affect future capital gains treatment? (currently it’s 50% tax free personal, 25% tax and reminding in corp).

    1. Good questions. I don’t think we’ll know exactly how they’ll do it until the legislation goes through.

      My guesses:
      1) I suspect that it will be on a year by year current tax year basis. That will make knowing where you stand as you go through the year vital if you are close and need to up your salary or give a bonus to decrease your active income. That approach would stack the odds of you accidentally going over in their favour which would fit their theme.
      2) If it were me, I would want more than 1.5% yield. If I had 8 million dollars [cue the Bare Naked Ladies music], I would likely have a higher proportion of “fixed income” than normal since I’d already “won the game” and would want to protect assests, but I would also want an overall portfolio yield higher than 1.5% since that would barely cover loss to inflation. I would stack the interest bearing stuff in my RRSPs and focus some capital gains or “return of capital” focused investments in my corp since that effectively increases the amount of passive income I could draw from my corp by double (only the taxable half of capital gains counts still). Depending on your life phase, I would have growth or dividend income in my TFSA and taxable accounts. If still needed more fixed income room to get my balance, I would consider some whole or universal life insurance in the corp, but that needs a fifteen to twenty year lead time to do properly. I think to effectively grow a portfolio that size, you would need to use multiple approaches beyond the corp. If I had 8 million dollars, I would also buy some gourmet ketchups for my Kraft dinner😜

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