2018 Budget Simplifies Passive Investment Rule

The 2018 federal budget introduced measures to simplify the new taxation regime for passive investments held inside a private corporation. These changes bring some long-anticipated clarity to a significant aspect of Finance’s recent private corporation tax proposals. The new rules provide that the amount of income eligible for the small business tax rate will be reduced depending on the amount of investment income held. In addition, the budget proposes new rules for CCPCs to access refundable taxes on the distribution of certain dividends. The rules, which also include certain anti-avoidance measures, will apply for taxation years beginning after 2018.

In July 2017, Finance released a consultation paper and proposed rules to address certain tax planning involving private corporations, including income sprinkling using private corporations, the conversion of a private corporation’s income into capital gains, and the accumulation of surplus savings and other passive investments in a private corporation. In October 2017, Finance announced that it was abandoning its capital gains measures and that there would be no tax increase on passive investment income below a $50,000 annual threshold. At that time, Finance indicated that it would provide additional details on the passive investment regime in its 2018 federal budget.

Finance also indicated that it intends to proceed with its tax measures, released on December 13, 2017, to address income sprinkling. These rules will likely be included in one of the budget implementation bills.

The federal budget’s passive investment income rules propose to reduce the small business limit for CCPCs (and associated corporations) that have a certain threshold of income from passive investments. The limit applies on a straightline basis for CCPCs that have between $50,000 and $150,000 of investment income. The budget also reduces the small business deduction by $5 for every $1 of investment income above the $50,000 threshold, so that the business limit would be eliminated for investment income of more than $150,000. As a result, a corporation’s access to the small business deduction could now be restricted or eliminated entirely if the corporation
(or a corporation within the associated group) earns passive investment income in excess of $50,000.

The new business limit reduction will operate in tandem with the existing business limit reduction for taxable capital. Currently, the existing rules reduce the business limit for taxable capital between $10 million and $15 million employed in Canada of the corporation and associated corporations. The reduction in a corporation’s business limit will be the greater of the reduction under the new measures and the reduction under the existing taxable reduction provisions.

To determine a corporation’s investment income, the budget proposes a new concept, “adjusted aggregate investment income” (AAII). Generally, aa ii will include dividends from non-connected corporations and income from savings in a life insurance policy that is not an exempt policy but will exclude taxable capital gains (and allowable capital losses) from the sale of active investments and investment income that is incidental to the business. It appears that these exclusions are intended to continue to encourage venture capitalists and angel investors to foster Canadian innovation.

The budget also proposes to limit certain tax advantages that CCPCs can use to access refundable taxes on the distribution of certain dividends. Specifically, the proposals allow a refund of RDTOH only when a private corporation pays noneligible dividends; currently, a corporation can receive the refund upon the payment of an eligible dividend. The budget also proposes an exception for RDTOH that arises when a corporation receives eligible portfolio dividends. The corporation will still be able to obtain a refund of that RDTOH upon the payment of eligible dividends.

To address the refund of taxes associated with portfolio dividends, the budget proposes to introduce a two- RDTOH pool system under which a new “eligible RDTOH ” account will track refundable taxes paid under part iv of the Act, while the current RDTOH account, now redefined as “non-eligible
RDTOH,” will track refundable taxes paid under part I and part IV (on non-eligible portfolio dividends). A taxpayer will be able to obtain refunds from its non-eligible RDTOH account only upon the payment of non-eligible dividends. When a private corporation pays non-eligible dividends, the corporate dividend refund must come out of its non-eligible RDTOH account before it comes out of its eligible RDTOH account.

The budget also includes specific transitional rules for existing RDTOH balances. Generally, these rules state that a CCPC’s opening eligible RDTOH account will be the lesser of its existing RDTOH balance and 38.33 percent of its grip. Any remaining RDTOH balance for the CCPC will be added to the opening non-eligible RDTOH account balance. For all other private corporations, the existing RDTOH balance will be added to the opening eligible RDTOH account.

As a result of these changes, corporations will no longer be able to recover RDTOH through the payment of an eligible dividend, which resulted in a lower tax rate than Finance intended to apply. To recover RDTOH, the corporation may first be required to pay non-eligible dividends, which are generally taxed at higher rates than eligible dividends (for example, approximately 9.5 percent higher at the highest marginal tax rate in British Columbia in 2018)