On February 27, 2018, the Federal government tabled its annual budget: “Equality and Growth for a Strong Middle Class” (the “Budget”). In the July 18, 2017 private corporation tax proposals , the government proposed changes to the taxation of passive investment income earned by Canadian controlled private corporations (“CCPCs”). The Budget includes a new regime for the taxation of CCPCs that earn passive investment income.
In the Budget, the government proposed two measures that will impact CCPCs earning investment income. It is generally agreed upon by most tax practitioners that these measures are a welcome departure from the original July 18th proposals.
The First Measure – Limiting Access to the Small Business Deduction (“SBD”)
Under this first measure, access to the SBD will be limited for CCPCs which earn more than $50,000 in passive investment income in a tax year. The measure would reduce the SBD limit by $5 for every $1 of passive investment income in excess of $50,000. The SBD is eliminated completely at $150,000 of passive investment income annually.
According to the government, the $50,000 threshold is the equivalent of the amount of investment income earned on $1 million in investment assets which earn a 5% rate of return. The SBD is eliminated at $150,000 in passive investment income, which represents, under the government’s model, $3 million in investment assets at a 5% rate of return.
In order to determine the reduction of the SBD limit of a CCPC, investment income will be measured by the new concept of “adjusted aggregate investment income.” This new concept is based on aggregate investment income (which is currently used to calculate the amount of refundable taxes with respect to a CCPC’s investment income) with some adjustments.
This first measure will apply to tax years that begin after 2018.
The Second Measure – Refundability of Taxes on Investment Income
Under the second measure, the government is proposing that taxes paid on investment income will only be refunded when dividends are paid out of the investment income which generated the refundable taxes. Refunds of the refundable tax will not be available when dividends are paid out of active business income.
Shareholders receive two types of taxable dividends from CCPCs: “eligible” and “non-eligible.” Eligible dividends are taxed at a lower rate to the shareholder compared to non-eligible. Investment income earned by a CCPC is usually paid to a shareholder as a non-eligible dividend. However, refundable dividend tax on hand (“RDTOH”) is currently not dependent on whether a dividend paid by a corporation is an eligible or non-eligible dividend. The current system, then, provides a tax advantage by allowing CCPCs to pay eligible dividends sourced from active business income to generate a refund of the RDTOH.
The Budget will amend the rules which provide a refund of RDTOH. RDTOH will only be available where a CCPC pays a non-eligible dividend. There will be an exception for RDTOH which arises from “eligible portfolio dividends” received by a CCPC. This exception will be achieved through two RDTOH accounts: eligible RDTOH (a new account) and non-eligible RDTOH (the current account). The eligible RDTOH account will track refundable taxes paid under Part IV of the Income Tax Act on eligible portfolio dividends. If a corporation pays an eligible dividend, it will be entitled to a refund so long as it has a positive balance in the eligible RDTOH account. If a corporation pays a non-eligible RDTOH, it will only be entitled to a dividend refund provided it has a positive balance in either account. Where a corporation pays a non-eligible dividend, the non-eligible RDTOH account must be reduced first.
The practical impact of this rule is still being analyzed among tax practitioners. This second measure will also apply to tax years that begin after 2018.
Other Tax Highlights of the Budget
Corporate Tax Rates
As of January 1, 2018, the small business tax rate is 10 percent and it will be reduced to 9 percent effective January 1, 2019.
Personal Tax Rates
Personal tax rates remain unchanged. However, the government did confirm that it will proceed with the proposed tax on split income measures which were announced on December 13, 2017
Reporting Requirements for Trusts
The Budget proposes to require certain “express” trusts to file a T3 Trust Income Tax and Information Return where such obligation currently does not exist and require trusts to provide information with respect to the trust’s trustees, beneficiaries, settlors and protectors. The reporting requirements will be applicable in 2021 and subsequent tax years. This change is consistent with a wider desire of government to seek the disclosure of beneficial ownership of trusts and corporations.
The new reporting will not apply to: mutual fund trusts, trusts governed by registered plans, lawyers’ general trust accounts; gradated rate estates; qualified disability trusts, among others.
A new penalty will be introduced for failing to file a T3 return with the required beneficial ownership schedule. The penalty will equal $25 per day for failing to file with a minimum $100 penalty and up to a maximum of $2,500.
At-Risk Rules
The “at-risk” rules limit the deductibility in partnership losses to the partner’s “at-risk amount.” A Federal Court of Appeal decision[1] held that the “at-risk” rules did not apply to tiered partnerships. The Budget will reverse this decision.
Foreign Affiliate Reporting
A taxpayer must file Form T1134, Information Return Relating to Controlled and Non-Controlled Foreign Affiliates within 15 months after the end of the taxpayer’s tax year. For taxation years of a taxpayer that begin after 2019, the Form T1134 is filed within six months after the end of the taxpayer’s tax year.
Reassessments
The Canada Revenue Agency (“CRA”) generally has three or four years (depending on the taxpayer) after the date of the taxpayer’s initial assessment to audit and reassess the taxpayer (the “reassessment period”). After this period, the CRA is generally barred from reassessing. Currently, there is a three-year extension to the reassessment period in respect of assessments made because of a transaction involving a non-arm’s length non-resident. This extension does not apply to foreign affiliates. The Budget extends the reassessment period for a taxpayer by three years in respect of income arising in connection with a foreign affiliate of a taxpayer.
This change takes place on or after Budget day.
[1] Canada v Green, 2017 FCA 107.