In the Summer of 2017, the Canadian government dropped a tax bomb on Canadian small business owners with proposed changes to how they are able to split their income and their ability to invest excess cash flow into passive investments.  While they had some vague guidelines, they did not have concrete rules to wrap our heads around.  All we had was speculation.

They have since provided clarification on income sprinkling and Federal Budget 2018 provided clarity on the rules around passive investment portfolios within a private corporation.

Background information

As many of you know, I use my corporate cash to invest in dividend stocks.  Investment income within a corporation is taxed at a high rate, however, if public dividends are flowed through to shareholders, the dividend will be taxed at the shareholder’s personal tax rate.

Related:  More info on the corporate dividend strategy and how to build a dividend portfolio.

The perceived advantage is that corporations can invest more upfront due to the lower small business tax (on revenues up to $500k).  In other words, there are more after-tax dollars to invest with compared to if the money was withdrawn to a shareholder, personally taxed, then invested.

The proposal is not clear on the exact changes with passive investing within a corporation, but one proposed change is to eliminate the capital dividend account (CDA) from passive investment income.  The CDA basically allows 50% of the capital gain to flow through to a shareholder tax-free, and the other 50% to be taxed at a high corporate rate (~47%).

I suspect that they’ll come up with more schemes to make it very unattractive to build a portfolio within a corporate account.  Some good news though, there is some indication that existing corporate passive investment accounts will be exempt.

Passive Investment Portfolios within a Corporation

Finally some clarification on the rules, and some good news upfront – they didn’t mess with the capital dividend account (CDA) as mentioned above.

Essentially, they set a threshold for passive income within a private corporation to $50,000 per year.  What counts as passive income?  Dividends, interest, and 50% of capital gains.  A simple example is that if you have a $1M portfolio that generates $50,000 through a combination of dividends, interest, and capital gains (50%), you’d still be onside.

The penalty for going over $50k in passive income is what I was most concerned about, but it’s actually not as bad as I anticipated.

Once your company generates more than $50,000 in passive income within a private corporation, access to the small business tax rate will gradually reduce until it is eliminated when/if you hit $150,000 in passive income.

To rewind a little, small businesses get access to the small business tax rate for the first $500k in active earnings (approx 10% tax rate).  After $500k, active earnings are taxed at the general tax rate of 15%.

So if you have a portfolio within your corporation that generates more than $50k/year in passive income, more of your corporate active income will face the higher general tax rate.

The small business deduction limit will get reduced by $5 for every $1 in excess passive income.  I can illustrate this better with a table.

The table below is a summary of the tax penalty by the amount of passive income.  The table assumes:

  • Small business tax rate of 10%;
  • General corporate tax rate of 15%; and,
  • Active earnings greater than $500k. 

This table shows the federal tax penalty only.  The penalties will be much higher if the provinces follow.

Passive Income Small Biz Deduction Limit Tax Penalty
$50,000.00 $500,000.00 $0.00
$60,000.00 $450,000.00 $2,500.00
$70,000.00 $400,000.00 $5,000.00
$80,000.00 $350,000.00 $7,500.00
$90,000.00 $300,000.00 $10,000.00
$100,000.00 $250,000.00 $12,500.00
$110,000.00 $200,000.00 $15,000.00
$120,000.00 $150,000.00 $17,500.00
$130,000.00 $100,000.00 $20,000.00
$140,000.00 $50,000.00 $22,500.00
$150,000.00 $0.00 $25,000.00

For example, let’s say that your corp has $80k in passive income which is $30k over the limit.  This means that $30k * 5 = $150k is removed from the small business preferred tax threshold.

In other words, only $350k of active business income is eligible under the small business tax rate of 10% rather than the general corporate tax rate of 15%.  In this case, the business owner would pay an additional $150k * 5% = $7,500 in corporate tax (following the assumptions in the table above).

Remember that the numbers above assume that your corporation makes over $500k in earnings annually.  If your corp make less, it simply means that your passive income threshold is higher without impacting your company in terms of taxes.  So if your corporation earns regularly $200k per year, you can generate passive income of up to $110k without any tax penalties.

The companies/shareholders that will be taking the biggest hit are ones that generate $500k or greater in earnings and have large passive portfolios within their corporation (think Dr. Specialist that is near retirement with a $10M portfolio).  While the new rules may hurt if the Doctor continues to work, but it will work out once she/he retires and lives off the portfolio (ie. no more active income).  I can see these new rules as an incentive for earlier than planned retirement for some professionals!

I can also see larger passive portfolios within a corporation shifting to investments that have very little or no distributions.  No distributions mean no impact on the small business tax rate.  Here are some ways to index a portfolio with no distributions.

One more thing – they will not be grandfathering any existing accounts, so these new rules are in effect for all passive portfolios within a corporation.

On a personal level, since our company is small, and generates well under the $50k threshold,  these changes have little impact on our financial strategy going forward.  What about you?  What are your thoughts on the new passive income rules?

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