When Finance Minister Bill Morneau tabled the 2018 federal budget on 27 February, there was no great roar of excitement among small business owners. However, amid the notable lack of cheers, one point was also plainly evident: it could have been worse.
Back in July 2017, Mr. Morneau announced plans for an abrupt and aggressive overhaul of various aspects of the Income Tax Act targeting Canadian-controlled private corporations (CCPCs). These proposals were met with vocal opposition from a small business community under siege, and we previously wrote about the potential harm that could result from the proposed changes in a blog post and an open letter to Mr. Morneau.
Fast-forward seven months and it seems the government has backed down at least somewhat from its initial draconian proposals. Below we highlight two areas – passive investments and income sprinkling – where the new budget will make life more difficult for small businesses, but not to the extent we had initially feared.
For small business owners with surplus income, retaining these funds within a CCPC and investing them in passive investments had been a smart strategy for achieving tax-advantaged growth. From 2018 onward, the tax advantages from this strategy are greatly diminished.
July 2017 proposal: Mr. Morneau proposed to eliminate the tax advantages of keeping excess funds within a CCPC and using them for passive investments – a practice that defers any personal income tax payable until the business owners withdraw the funds from the corporation.
Budget 2018: Rather than eliminating entirely the tax advantages of passive investments within a CCPC, the government is effectively capping the extent to which business owners can gain tax benefits from such passive investments. This is being implemented via two new rules.
First, a rule that gradually reduces a CCPC’s access to the lower small business tax rate and instead applies the higher general corporate tax rate when passive investment income exceeds $50,000; once passive investment income climbs above $150,000, all business income is taxed at the general corporate rate.
Second, a rule that places restrictions on a CCPC’s access to tax refunds – arcanely named the refundable dividend tax on hand (RDTOH) – for certain dividend payments. You can find more details about how these two rules will impact private corporations with passive investment income in this Department of Finance tax measures overview.
Small business owners have long used dividend payments from a CCPC to split their income with family members in lower income tax brackets. While this will remain possible going forward, the government is restricting the situations in which such “income sprinkling” is permitted.
July 2017 proposal: Mr. Morneau proposed to limit income sprinkling by requiring that dividends paid by a CCPC to the business owners’ family members be reasonable and paid only to individuals actively involved in the business.
Budget 2018: The government confirmed that it will be moving forward with an amended version of the income sprinkling proposals announced on 13 December 2017. These amended proposals aim to simplify the process for determining whether dividend payments are “reasonable” and list several situations in which family members are excluded from having their dividend payments taxed at higher rates.
Compared to the July proposals, these exclusions provide greater clarity and represent a lower hurdle for family members (such as the business owner’s spouse or adult children) to overcome to receive payments from a CCPC without being penalized. For more details, check out this backgrounder from the Department of Finance.
Optimizing for a new tax reality
With Budget 2018, Mr. Morneau introduced tax measures that will make life a bit more difficult for some small business owners. While we would have preferred to see things move in the opposite direction, we must acknowledge that the new rules are a dramatic improvement compared to the first round of proposals last July. Of course, this is no great accomplishment given that the first go-round was outrageous.
If you have questions about how you might be impacted by Budget 2018 and how to optimize your business under the new rules, please contact us.